Basics of Economics

Recently I started reading a book called Day to day economics by Satish Y. Deodhar. The book explains in layman's language what the complex economical terms mean.

So what I have decided is as I read this book I will make notes and update the blog so that you can also proceed with me and know about basic economic theories.

I finished the first chapter of this book which is called 'Medley of Government and Private sector'. The key theories that are covered in this section are:

1.  Externality:

Positive and Negative Externalities

An externality is defined as a benefit or cost that is imposed on a third party, such as society, other than the producer or consumer of a good or service, or, more simply, an economic side effect. The more of a product that is consumed or produced, the more of an externality that results. When discussing externalities in general terms, positive externalities refer to the benefits and negative externalities refer to the costs associated with the production or consumption of a good or service.

Externalities are not usually fully reflected in prices. Externalities are regarded as a form of market failure. The costs and benefits related to externalities are not typically included as part of the decision to complete the economic activity. Given this, the chosen volume or frequency of activity is not directly related to the externality and becomes an inefficiency in terms of resource use. Negative externalities cause too much of a product to be produced and positive externalities cause too little of a product's production. When considered as a supply-demand graph for a positive externality, the marginal benefit curve perceived by the decision maker will be to the left of the marginal benefit curve of society. This shows too little activity taking place.

Public goods are one of the more common examples of positive externalities. Public goods are goods which are difficult to exclude people from benefiting from or from getting a free ride. Public goods, such as national defense, clean water, clean air, law enforcement, etc., are generally good for most, if not all of society.

Negative externalities exist in many situations. One of the most common examples is that of pollution. In these situations, the producer and consumer finance the goods produced but society must bear the cost of pollution that is introduced into the environment as a by-product and is thus a negative externality. For example, a factory that produces widgets generates a hazardous by-product from the widget production process. It dumps the by-product in neighboring stream. The more widgets produced, the more by-product is produced and thus the more pollution that goes into the water. The factory may bear some of the cost of the pollution but not all. Any remaining cost is borne by society. In this situation and in the event of the absence of well-defined property rights there may be an issue of how much pollution may be dumped into the water or if it can be dumped into the water at all plus an issue over who is responsible for the cost of the pollution. In the absence of well-defined property rights, it may be necessary for the government to step in to introduce regulation, legislation, taxes, etc. to address the situation. An example where the government addressed an issue was the Clean Air Act.

Examples of Externalities

Positive externality:

Immunizations, such as a flu shot, etc., provide a positive externality to third parties in that it helps prevent the spread of illness in the general public.

A company provides funds for its employees to obtain specialized training or degrees. By doing so, the company can be benefited by increased production which also benefits the customer. At the same time, this can benefit society as a whole by increasing the level of education, quality of life, etc.

Significant home improvements will not only raise a person's property value, but it will also increase the values of the home nearby.

Improving driving habits will decrease the risk of accident for everyone on the road as well as eventually reduce insurance premiums of the driver.

Negative externality:

Pollution from a factory can cause health problems and erode the quality of life and property values in a community.

A power plant that burns coal to generate electricity emits pollution. The more electricity that is demanded by customers, the more coal that is burned in order to produce it. Increasing the amount of coal burned to generate electricity thus increases the level of pollutants emitted into the atmosphere that can lead to such things as global warming, acid rain and smog.

Second-hand cigarette smoke causes health problems in people other than smoker.

A loud party next door can cause those not involved in the festivities to lose sleep.

2.  Natural monopoly:

Have you heard that business monopolies are bad for consumers? When a monopoly exists and only one business offers a product or service, it could charge whatever it wants, and consumers could suffer. This is certainly a valid concern, and it explains why the government has anti-trust laws, to help ensure that there is adequate competition for various goods and services in the economy. There are instances, however, where a monopoly may exist that benefits all of us. Let's explore what type of monopoly that is and why it is beneficial.

A natural monopoly is a specific type of monopoly that can arise when there are very high fixed costs or other barriers to entry in getting started in a certain business or delivering a product or service. This creates a situation where it is more efficient for one business to deliver a product than multiple businesses. In these situations, there are often government regulations to prevent high prices and corruption. This efficiency results in lower average costs for us.

Can you think of an industry that would be difficult to enter because it would require huge start-up costs? One example may be the gas utility company that you pay to heat your home and water. Can you imagine all the land, facilities, machinery and technology you would have to purchase, as well as all the pipelines you would have to lay, to start in this business? These extremely high capital costs are often referred to as barriers to entry. Barriers to entry, such as high start-up costs, specialized technology, or difficult licensing and regulation requirements in an industry, limit the number of possible entrants into the industry. It is simply too expensive and risky to get started.

Let's take a look at some natural monopolies that you are very familiar with.

Examples

Water Services - An example of a natural monopoly is the company that provides the water we drink out of the kitchen faucet. To have two, three, or four companies all lay pipes throughout the city and into every home would be inefficient and a waste of money. All of these additional costs from companies to lay the proper infrastructure, have their own treatment facilities, and hire their own staff would certainly raise the price you pay for water services. This is a classic situation where lower average costs are created when there is only one provider.

3.  Non excludability

4.  Non rivalry in consumption

Some goods, like apples, are subject to consumption rivalry. If I eat the apple, it is no longer available to anybody else. But other goods are not subject to consumption rivalry. Many people can tune in to the same radio signals at once without degrading them.

Similarly, it is easy to exclude non-paying customers for apples. But it is impossible to exclude free riders on public radio signals.

We can classify goods by drawing a two-by-two matrix based on high or low rivalry on the one hand and high or low excludability on the other as follows:

Rivalry and excludability are related. If there is no rivalry in consumption, there is no reason to exclude except to raise funds. But funding availability does not eliminate rivalry. One apple cannot be shared with an unlimited number of people. So goods subject to consumption rivalry will never become public goods.

On the other hand, how non-rival goods are funded can determine whether a good becomes a public good or simply a low-congestion good. For example, a search engine with practically unlimited capacity for search traffic would become a public good if it is indirectly supported through advertising revenues. But the same search engine would become a low-congestion good if it is fee-based. It is technically feasible to exclude users in either case, but there is no point to exclude if excluding some users might reduce the amount of ad-supported revenues.

Both indirect funding of public goods and direct fees for low-congestion goods are means to avoid free-ridership where some users enjoy the service without paying. When a good is not subject to consumption rivalry, indirect funding would generate maximum benefit because even users with low marginal benefit will be attracted to the zero marginal cost. But the content of the goods might be affected by how the service is funded. For example, over the air network TV and Public Television are both public goods, but there is a tendency for TV networks to appeal to the lowest common denominator in order to maximize ad revenues.

Conversely, if there is rivalry in consumption, there is every reason to exclude. Both private goods and commons goods are subject to consumption rivalry. But it is much more difficult to clearly define and enforce the property rights for commons goods. Hence the tragedy of the commons.

High enforcement cost can transform private goods into de facto commons goods and low-congestion goods into de facto public goods. For example, the unfenced front lawn of your house (private good) has become the public toilet (commons goods) of your neighbors' dogs. And private-label digital music (low-congestion good) has become a freebie (public good) for the file-sharing community.

5.  (Pure) public good

6.  Club good:

There are several types of goods in economics: private goods, public goods, club goods, and common goods. What defines which category a good will fall into?

The category can be determined knowing two things: Is the good rival? Is it excludable?

If a good is rival, one person using it prevents someone else from using it. This is a bit of a weird concept, since air can only be breathed by one person at a time, but air is so abundant as to be nonrival. Air in a SCUBA tank, though, would be rival, since only one person can breathe from it at a time. If a good is excludable, you can prevent someone from using the good if you don’t want them to. My apartment is excludable because I have a lock on the door.

Private goods are rival and excludable. Just about anything you can think of going to a store and buying is a private good. My TI-36X Pro calculator is rival (if you’re using it, I can’t) and it’s excludable (if I don’t want you to use it, I’ll just put it in my pocket). Private goods have some interesting properties and merit further discussion.

Public goods are defined as goods that are nonrival and nonexcludable. The classic example of a public good is military defense. If the Army exists and prevents other countries from invading the United States, then there’s no way to keep me from benefiting from that defense that doesn’t also prevent someone else (e.g., my no-good brother) from benefiting (so defense is nonexcludable). Similarly, defending the United States is nonrival because the fact that I’m defended doesn’t have any effect on how defended someone else is. I don’t use up military defense, so it doesn’t (in the simplest case) cost anything to defend my neighbor if I’m already being defended.

Club goods are excludable but nonrival. My landlord’s wireless internet connection is a club good. It’s excludable, because there’s a password on it; it’s nonrival, though, because up to a certain point it doesn’t matter how many people are connected to the network. My enjoyment of the internet doesn’t depend on whether my wife is online or not. (It would take a whole bunch of people, enough to cause congestion, to make my internet too slow to use.)

Common goods are pretty interesting, because there’s an intuitive concept called the tragedy of the commons. Common goods are rival, but nonexcludable. The classic example here is a meadow where you graze your sheep. Every one of us can use the meadow, since it’s public property, but if I graze my sheep here, they eat some of the grass and there’s less for your sheep. It’s in both of our interests to conserve the meadow, but it’s also in both of our interests to cheat and consume as much as we want to. Common goods tend to get used up.

(to be continued...)
Source:
Internet
Day to Day economics by Satish Y Deodhar